The macroeconomic economic backdrop over the past few years was the perfect landscape for real estate investment trusts.
The sector has used a number of tools to strengthen capital structures and continued improvement in operating fundamentals, resulting in a stable outlook for REITs, according to Moody’s Investor Service.
"REITs have lengthened their debt maturity profiles by accessing bank, bond and preferred capital and refinancing at historically low interest rates," said Moody’s Associate Managing Director Philip Kibel.
He further explained, “The added liquidity resulted in higher earnings and fixed-charge coverage ratios."
With the rise in both single-family home prices and mortgage rates in recent months, apartment demand will remain strong so long as the recovering job market does not falter.
Consequently, the multifamily sector will continue to benefit from short-term leases, allowing owners to raise rents as the economy recovers – particularly because declining homeownership has boosted demand and new supply remains modest in most markets.
The strong share prices and asset pricing continues to help REITs raise equity, subsequently lowering leverage from pre-recession levels.
While REITs will ultimately have to contend with higher interest rates, many market analysts believe the impact will be manageable.
"In general, companies with longer average debt maturity schedules and relatively better internal and external growth profiles should be able to mitigate the negative effects on higher interest rates on cash flows a bit better," explained Morningstar Credit Ratings analyst Todd Lukasik.
Additionally, if a stronger economy and higher levels of inflation accompany higher interest rates — REITs with shorter lease terms — may provide some protection because they should be able to raise rents on their tenants faster than those with longer lease terms.
Nonetheless, rising interest rates will be a headwind for all REITs, and investors should be prepared for potential downside risk to share prices in a rising rate environment, cautioned Lukasik.
As REITs continue to progress over the next two years, maintaining liquidity will be less of a concern than maintaining reasonable leverage portfolios.
Thus far, REITs have used a prudent mix of debt and equity to fund growth opportunities that improve market position and long-term earnings, Fitch noted.
"Rising capital costs may tempt REITs to use more debt funding in pursuit of higher-levered returns," Kibel stated.
Going forward, REIT investors should be on the look out for potential excess in new supply and economic shocks that may weaken real estate demand.
However, sector fundamentals are on a good trajectory even if demand does slow down, Kibel concluded.